New York State Bar Association

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1 REPORT #522 TAX SECTION New York State Bar Association 1986 TAX REFORM ACT SEMINARS Table of Contents I. An Overview... 1 II. Taxpayers Subject to PAL Rule... 1 A. Individuals, Estates and Trusts [sec B. Closely Held C Corporations Described in Section 465(a)(1)(B)... 2 C. Affiliated Corporations III. Definition and Computations of PALs... 2 A. Aggregate v. Segmented Computation B. Treatment of Prior Years PAL C. Definition of PAL D. Definition of Passive Activities... 3 E. Exceptions for $25,000 Real Estate Losses and Working Interest in Oil and Gas Properties (1) Real Estate... 4 (2) Working Interests in Oil and Gas property... 5 F. Rules for Calculating PALs and Interrelationship with Investment Interest Limitations (1) Personal Service Income... 5 (2) Reflections on Imputed Personal Service Income... 6 (3) Interest Expense... 7 (4) Stacking of Losses... 8 IV. Material Participation Defined... 8 A. Requirement of Regularity, Continuity, and Substantiality B. Application to C Corporations... 9 C. Limited partnership D. Participation by Spouse... 10

2 E. Regulatory Authority and Anti-Abuse Rules V. Rental Activity and Portfolio Income Defined A. Rental Activity B. Straining out Rental Income and Deductions C. Portfolio Income D. Exception for Pass-Through Interest VI. Scope of an Activity VII. Disposition of Interest in Passive Activity; or Interest Becoming Non-Passive A. Disposition on Death B. Disposition of 100% of Interest in Taxable (1) Stacking of Losses (2) Multiple Activities and Multiple Entities (3) Sham Transactions, Wash Sales, Etc (4) Related Party Dispositions (5) Insurance Syndicates (6) Dispositions by Abandonment (7) Interaction with Capital Loss Transactions C. Disposition on Installment Sales D. Disposition by Gift E. Passive Activity Becoming Active F. Tax-Free Exchanges VIII. Limitations on Deductions for Non-Business Interest.. 20 A. Key Statutory Terms in Defining Investment Interest B. Property Held for Investment C. Investment Interest and Personal Interest D. Investment Income IX. Phase-in; Transition Rules; Application to Minimum Tax.. 23 X. Examples and Queries as to the Application of PAL and Non- Business Interest Rules to Trading in Commodities, Options and Securities... 23

3 REPORT #545 NEW YORK STATE BAR ASSOCIATION TAX SECTION 1986 TAX REFORM ACT SEMINARS SESSION ONE: EFFECT OF THE 1986 ACT ON BUSINESS AND INVESTMENT ACTIVITIES OF INDIVIDUALS Legislative Overview; Passive Loss Rules; Limitations on Interest Deductions and Section 212 Expenses; Individual Alternative Minimum Tax OCTOBER 9, 1986

4 LIMITATIONS ON LOSSES FROM PASSIVE ACTIVITIES AND ON DEDUCTIONS FOR NON-BUSINESS INTEREST Donald Schapiro 1986, Donald Schapiro

5 I. An Overview A. Section 469(a) defers the passive activity loss ( PALL ) and passive activity credit in the case of specific taxpayers. are: B. Obvious major issues raised by this rule (1) To which taxpayers does section 469 apply? (2) What is a PAL? (3) Under what circumstance does a deferred PAL become allowable, and under what circumstances does the deferred PAL disappear or get added to the basis of some property? (4) How do the rules of section 469 interrelate with other deferral or disallowance rules such as the at risk provisions and investment interest limitations? II. Taxpayers Subject to PAL Rule A. Individuals, Estates and Trusts [sec. 469(a)(1)(A)] and Personal Service Corporation [sec. 469(a)(1)(C) and 469(j)(2)]. Personal service corporations are those described in section 269A(b)(1) with modifications, viz., corporations whose principal activity is the performance of personal services where such services are substantially performed by owner-employees. A person is an owner-employee if such person owns any stock actually or constructively under section 318, with complete passthrough to shareholders of stock held by corporations. The definition of a personal service corporation, for purposes of the PAL rule, does not include a corporation This outline doe not discuss the passive activity credit. -1-

6 where the employee-owners together own less than 10% by value of a corporation s stock [sec. 469(j)(2)]. Conf. Rep., p * Query: Are services substantially performed by owner-employees only where such service constitute more than 50% of services performed? For example, would incorporated law firms meet the test if partners, (i.e., shareholders) bill 25% of hours billed and 40% of time value of hours billed? B. Closely Held C Corporations Described in Section 465(a)(1)(B) [secs. 469(a)(2)(B)and 469(j)(1)] These are C corporations meeting the personal holding company stock ownership rules of section 542(a) as to direct and indirect ownership of more than 50% of the stock by five or fewer individuals (including as individuals certain tax-exempt organizations). Note, however, that special more favorable PAL rules apply to closely held C corporations that to individuals and personal service corporations, viz: PAL can be offset against non-portfolio income [sec. 469(e)(2)]; and material participation in an activity can be derived from employee activity as well as shareholder activity [sec. 469(h)(4)(B)]. If a corporation ceases to be closely held or ceases to be a personal service corporation, it can continue to deduct unabsorbed PALs in the same manner as if status did not change [sec. 469(f)(2)]. Conf. Rep., pp. 139 and 140. C. Affiliated Corporations. In the case of affiliated corporations filing consolidated returns, it is intended that the PAL rules applicable to closely held corporations and personal service corporations be applied on a consolidated basis. Conf. Rep., p III. Definition and Computations of PALs A. Aggregate v. Segmented Computation. Computation of the aggregate PAL for a tax year is relevant in all tax activities may be relevant, e.g., as in the case of disposition of an activity with a deferred * House of Representatives Conference Report to accompany H.R. 3838, September 18, 1986, Vol. II is herein cited Conf. Rep. and pages are designated without prefixed roman numerals, viz. page II-139 of that report is cited Conf. Rep., p

7 attributable PAL; division of PALs among activities is on a pro-rata basis. Senate Finance Committee Report on H.R dated May 29, 1986 ( SFCR ), p B. Treatment of Prior Years PAL. At the end of any tax year, if the taxpayer has an unabsorbed PAL, then the year or years in which the PAL or its elements becomes a current PAL [sec. 469(b)] which will either be added to a current PAL [sec. 469(d)(1)], reduced by absorption through current year s income [sec. 469(d)(1)], left unaffected, or, as to particular segments of the aggregate PAL, eliminated in connection with a disposition of taxpayer s entire interest in the activity [sec. 469(g)]. C. Definition of PAL. PAL is defined as the amount by which the aggregate losses from all passive activities (having losses) exceed the aggregate income from passive activities (having income) [sec. 469(d)(1)]. All deductions that are from passive activities are taken into account, including those allowed under sections 162, 163, 164 and 165. Conf. Rep., p This computation includes the prior years unabsorbed PAL. NB It is always desirable for a taxpayer to have an item of income or gain placed in the passive activity basket, and to have an item of loss or deduction excluded from the passive activity basket. Thus, as discussed below, there are prophylactic rules designed to protect the revenue from misclassification of income items or income producing activities as passive. D. Definition of Passive Activities. The term passive activity means (1) any activity which involves the conduct of a trade or business in which taxpayer does not materially participate [sec. 469(c)(1)], (2) any rental activity [sec. 469(c)(2)], and (3) to the extent provided by regulation, an activity in connection with a trade or business or any activity with respect to which Section 212 deductions are allowable [sec. 469(c)(6)]. For purposes of section 469(c)(1)(A), a trade or business includes activities generating deductions allowable under section 174 as R & D expenditures [sec. 469(c)(5)]. Regulatory authority is meant to cause the PAL rules to apply to activities that give rise to passive losses intended to be limited under the PAL provisions but that -3-

8 may not rise to the level of a trade or business. [Conf. Rep., p. 138] In determining income or loss for purposes of calculating the taxpayer s PAL, portfolio income or loss, as described below, is eliminated [sec. 469(e)(1)]. See Exhibit A attached for diagrammatic representation. E. Exceptions for $25,000 Real Estate Losses and Working Interest in Oil and Gas Properties. (1) Real Estate [sec. 469(i)]. If an individual actively participates in rental real estate activities, up to $25,000 of the individual s PAL in any year attributable to such activities is not disallowed. The exemption phases out after tax payer s income exceeds $100,000. Taxpayer and spouse must own at least a 10% interest in real estate and cannot hold the interest through a limited partnership. Note that in a year in which rental real estate has income, this income has favorable status as passive activity income. In the case of this $25,000 allowance for passive losses from rental real estate, such losses, if not offset against other income in a particular year, may be carried forward as part of a net operating loss. SFCR, p In applying the $25,000 real estate allowance for active participation, income and loss from all of a taxpayer s real estate activities are first netted [Conf. Rep., p. 141]. Example: Assume a taxpayer has $25,000 of losses from a real estate activity in which he actively participates, and $25,000 of gain from another real estate activity in which he also actively participates resulting in no net loss from real estate activities. Assume further the taxpayer has net losses of $20,000 from other passive activities for the year. On these facts, the real estate gains and losses would be netted, and the taxpayer would have a $20,000 PAL from the other passive activities. If the taxpayer who does not actively participate in a real estate activity in year one has -4-

9 a PAL in the year, and then begins to actively participate in year two, the PAL from year one remains a PAL. Real estate losses greater than $25,000 arising in a year where taxpayer actively participates are carried over and allowable under $25,000 rule in a subsequent year if the taxpayer actively participates in the activity in a subsequent year. Conf. Rep., p Where a taxpayer who dies actively participated in a real estate activity, his estate is deemed actively participating for two year following the death of the taxpayer so the estate can receive the same tax treatment with respect to the real estate activity as the taxpayer with respect to the real estate activity as the taxpayer did in the taxable year of his death [sec. 469(i)(4)]. Conf. Rep., pp. 141 and 142. Trusts do not qualify for the allowance of up to $25,000 in losses from rental real estate, so taxpayers cannot circumvent the $25,000 ceiling or multiply the $25,000 allowance by transferring various rental real estate properties to one or more trusts. Conf. Rep., p (2) Working Interests in Oil and Gas property [sec. 469(c)(3)]. Income and loss from any working interest in any oil or gas property which taxpayer holds directly or through an entity which does not limit the liability of taxpayer with regard to such interest is eliminated in calculation of PAL. If any working interest produces losses treated as nonpassive, then any subsequent income from that property, or from any property where basis is determined by reference to such property, is treated as non-passive, thus precluding placing such income in the passive basket. F. Rules for Calculating PALs and Interrelationship with Investment Interest Limitations. Rules for allocating deductions to components taken into account in calculating passive income are provided in sections 469(e)(I)(A)(II) and (III) and 469(k)(4). (1) Personal Service Income. Section 469(e)(3) provides that earned income within the meaning of section 911(d)(2)(A) is not taken into -5-

10 account in computing income or loss from a passive activity. The [Senate Finance] committee intends that a share of partnership income, or a guaranteed payment to a partner (including a limited partner) attributable to the performance of personal services is not to be treated as passive. SFCR, p Conf. Rep., p. 139, clarifies that income received by an individual from performance of personal services with respect to a passive activity is not treated as income from this activity so that a limited partner who is paid for performing services for the partnership (whether by way of salary, guaranteed payment, or allocation of partnership income) cannot shelter such income by passive losses from the partnership or any other passive activity. (2) Reflections on Imputed Personal Service Income. The concept of imputing income for uncompensated personal services to one member of a group engaged in economic activities and thereby diminishing the taxable income of the other members is familiar. See e.g. section 1366(e) (in an S corporation, compensation can be imputed to persons providing uncompensated services) and section 704(e) (similar rule for family partnerships). It appears that the same type of analysis could be made under section 469 if an individual did not make a proper charge for services. The Senate Committee and Conference Reports cited in Paragraph F(1) above refer to a partner in a partnership, but the principle would presumably be applicable to the shareholders of an S corporation or to a sole proprietorship. Example (1): Assume an individual selfmanages rental property he own and provides management and repair services of a type which would have been recognized under section 163(d)(5)(B)(ii) of the Senate Bill (the value of certain imputed compensation considered expended for purposes of determining whether a net lease exists). [This provision does not appear in the Conference Bill.] -6-

11 If the taxable income of the property without regard to imputed personal service income is $1,000 and the fair market value of the imputed services is $1,500, does the individual have a PAL of $500? Suppose the personal services were in the nature of imputed income from leasing commissions for a two-year lease. Would the PAL be $750 in the first year on the basis that only half the imputed leasing commission would be deductible in the first year? Example (2): Suppose an individual manages his own investment portfolio on a fulltime basis. Assume the gross income of the portfolio is $10,000 and the fair market value of the uncompensated services is $1,000. Query whether the individual is taxable on $1,000 of compensation income and has a $1,000 deduction under section 212 subject to the 2% deduction floor. (3) Interest Expense. Interest deductions attributable to passive activities are not treated as investment interest [sec. 163(d)(3)(B)(ii)]. Thus, these deductions are subject to limitation under the PAL rules and not under investment interest limitations. Income and loss from passive activities generally are not treated as investment income or loss in calculating the amount of the investment limitation [sec. 163(d)(4)(D)], but passive loss allowed by reason of the phase-in of the PAL provision (other than losses from rental activities in which the taxpayer actively participates) reduces net investment income. [Conf. Rep., p. 139.] Interest on a debt secured by taxpayer s residence is not taken into account even if borrowed funds are invested in a passive activity [sec. 469(j)(7) and SFCR, p. 720]. Query: If a partnership engaged in a rental real estate activity borrows money by mortgaging a profitable building and invests the funds in marketable securities, is the interest deduction on such borrowing attributable to the investment in the marketable securities, hence treated as investment interest deductible against investment and portfolio -7-

12 income, or is the interest deduction treated as arising from the passive rental activity, hence not deductible against portfolio income? What if the borrowing took place many years ago? How would use of funds be traced? The Conf. Rep., p. 146, states that Treasury regulations covering the area of interest allocation are to be promulgated by December 31, 1986 [sec. 469(k)(4)]. (4) Stacking of Losses. In determining the interrelationship between NOLs and suspended PALs, note that NOL carryovers, like current year losses other than PALs, are allowed against any income of the taxpayer. In the case of individuals, estates and trusts, and personal services corporations, however, such non-passive losses and NOLs are taken into account only after reducing income from passive activities by current and suspended deductions from passive activities (but not below zero). Thus the application of any prior year s suspended PALs against current year s passive income is taken into account before such NOLs are applied against net passive income, thus permitting the taxpayer to obtain the full benefit of suspended PALs which are limited in application before using any current losses that are not from passive activities or NOL carryovers. If the taxpayer has net passive activity income after application of all suspended PALs, income may be offset by current year non-passive losses and by NOL carryovers. SFCR, pp. 722 and 723. IV. Material Participation Defined A. Requirement of Regularity, Continuity, and Substantiality. Section 469(h)(1) provides that a taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous and substantial basis. This rule applies to individuals and, in the case of trusts and estates, the test is based on whether the fiduciary, as such, meets the meets the material participation standard, and in grantor trusts whether the grantor meets this standard. SFCR, p Regardless of whether an individual directly own an interest in a trade or business activity (e.g., as a proprietorship), or owns an interest in an activity conducted at the entity level by a passthrough entity -8-

13 such as a general partnership or S corporation, he must be involved in the operations of the activity on a regular, continuous, and substantial basis, in order to be materially participating. SFCR, p The Senate Finance Committee Report states that a taxpayer must materially participate in an activity throughout the taxable year. SFCR, p The Senate Finance Committee Report provides the following additional guidance (page 732): The material participation standard is based upon sections 1402(a), relating to self-employment tax, and 2032A, relating to valuation of farm property, but it is modified in accordance with the purposes of the passive loss provisions. However, applications of these preexisting legal standards are not intended to be controlling. Periodic consultation with respect to general management decisions will not create active participation. An individual s involvement must relate to operations to constitute material participation. Material participation is most likely to occur in cases where an activity is taxpayer s principal business. See further generally SFCR, pp The Conference Agreement endorses the meaning of material participation as set forth in the Senate Finance Committee Report. The Conf. Rep. clarifies that an individual who works full time in a line of business consisting of one or more business activities generally is likely to be materially participating in these activities (except to the extent provided otherwise in the case of rental activities) even if the individual s role is in management rather than operations. This clarification is not intended to alter the description of material participation in the Senate Finance Committee Report in any respect. The Conf. Rep. also clarifies that a taxpayer is likely to be materially participating in an activity if he does everything that is required to be done of conduct the activity, even though the actual amount of work to be done to conduct the activity is low in comparison with other activities. Conf. Rep., pp. 147 and 148. B. Application to C Corporations [sec. 469(h)(4)]. In the case of all corporations subject to the PAL rules, the taxpayer is treated as materially participating in an activity if one or more shareholders -9-

14 holding stock representing more than 50% (by value) of the outstanding stock of the corporation materially participate in the activity. In the case of closely held corporations, but not personal service corporations, a second test of material participation looks to services furnished by non-shareholder employees. C. Limited partnership [sec. 469(h)(2)]. In the case of limited partnerships, the holder of a limited partner s interest is treated as being engaged in a passive activity, irrespective of his actual participation as a limited partner or general partner. Where the taxpayer owns a limited partnership through a tiered arrangement, such as an S corporation or a general partnership, he is still deemed not to be actively participating in the business of the limited partnership. Where a taxpayer owns both a limited partnership interest and a general partnership interest with respect to the same activity, lack of material participation is conclusively presumed with respect to the limited partnership interest, even if the limited partner taxpayer may materially participate with respect to his general partnership interest. SFCR p However, where a limited partnership holds portfolio securities, income and gain from such securities are not considered passive income. SFCR, p D. Participation by Spouse. In determining whether a taxpayer materially participates (or actively participates), the participation of the spouse of the taxpayer is taken into account [sec. 469(h)(5)]. E. Regulatory Authority and Anti-Abuse Rules. The Secretary is granted specific authority to prescribe regulations which specify what constitutes material participation for purposes of section 469 [sec. 469(k)]. The Senate Finance Committee Report, p. 730, states: The Secretary may prescribe regulations under which items of income from a limited partnership or other passive activity are treated as portfolio income. The Senate Finance Committee Report states an intention that such regulation will prevent taxpayers from structuring income-producing activities (including those that do not bear significant expenses) in ways that are designed to produce passive income that may be offset by unrelated passive losses. For example, such regulations may provide that, where necessary to prevent avoidance of the passive -10-

15 loss rule, a limited partner s share of income from a limited partnership is treated as portfolio income. Circumstances in which such treatment could be appropriate would include a transfer by a corporation of an income-producing activity to a limited partnership with a distribution to shareholders of limited partnership interests. SFCR, p See also, SFCR, p The Conference Report states that in connection with the Treasury Regulations regarding definition of income that is treated as portfolio income or as otherwise not arising from a passive activity, Conferees intend that the regulatory authority be exercised to protect the underlying purpose of the passive loss provisions which is preventing the sheltering of positive income sources through the use of tax losses derived from passive business activities. Conf. Rep., p. 147, states: Examples where the exercise of such authority may (if the Secretary so determines) be appropriate include the following: (1) ground rents that produce income without significant expense; (2) related party leases or sub-leases with respect to property used in a business activity, that have the effect of reducing active business income and creating passive income; and (3) activities previously generating active business losses that taxpayer intentionally seeks to treat as passive at a time when they generate net income with the purpose of circumventing the rule. V. Rental Activity and Portfolio Income Defined. A. Rental Activity [sec. 469(j)(8)]. The following guidance is provided in the Senate Finance Committee Report at pages 741 and 742: Rental activity, which is specifically included as a part of passive activities, does not include any activity where payments are not principally for the use of tangible property. Hotel operations and short-term auto leasing are not rental income because personal services are involved. Old Sub S section 1372(e)(5) furnishes a useful analogy. Rental activity does not include payments for use of intangibles like stock or other payments more properly characterized as interest. The Conf. Rep., p. 148, notes that provision of washing machines in a laundry room of a -11-

16 rental apartment building would be part of rental activity. B. Straining out Rental Income and Deductions. In what many will view as a Draconian approach, the Senate Finance Committee Report describes rules which would make it very difficult to offset losses from rental of property against which could be viewed as integrally related. Thus the Senate Finance Committee Report provides as follows (p. 743): Some businesses involve the conduct of rental activities in association with other activities not involving renting tangible property. Although the other activities may immediately precede the rental activity, be conducted by the same persons, or take place in the same general location, they are not treated as a part of the rental activity, because under the passive loss rule rental activities are considered passive activities without regard to the taxpayer s material participation. In the case of other activities, an examination of the taxpayer s material participation generally determines whether an activity as passive. Rental activities generally are treated as separate from nonrental activities involving the same persons or property. Thus, for example, automobiles leasing is treated as a different activity from automobile manufacturing, and real estate construction and development is a different activity from renting the newly constructed building. Similarly, suppose a travel agency operated in the form of a general partnership has its offices on three floors of a ten-story building that it owns. The remainder of the space in the building is rented out to tenants. The travel agency expects to take over another floor for its own use in a year. The partnership is treated as being engaged in two separate activities: a travel agency activity and a rental real estate activity. Deductions and credits attributable to the building are allocable to the travel agency activity only to the extent that they relate to the space -12-

17 occupied by the travel agency during the taxable year. SFCR, p. 743 Consider here the possibility of imputing personal service income discussed in III-F(2) p. 6, supra. C. Portfolio Income [sec. 469(e)(1)(A)]. A fundamental exclusion from passive income is portfolio income defined as follows: In determining the income or loss from any activity - (A) IN GENERAL. There shall not be taken into account - (i) any (I) gross income from interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business, (II) expenses (other than interest) which are clearly and directly allocable to such gross income, and (III) interest expense properly allocable to such gross income; and (ii) gain or loss attributable to the disposition of property (I) producing income of a type described in clause (i), or (II) held for investment. For purposes of clause (ii), any interest in a passive activity shall not be treated as property held for investment. Expenses and interest allocable to portfolio income are not deemed attributable to a passive activity. Treasury is to issue regulations for allocation of expenses and interest to portfolio income by December 31, Conf. Rep., p Section 469(e)(1)(B) states that any income, gain, or loss which is attributable to an investment of working capital shall not be treated as arising in the ordinary course of a trade or business. See example at SFCR, p Example (1): Assume a limited partnership is actively engaged in trading stocks, bonds and other securities for gains and for dividend and interest income. The partnership is not, however, a dealer in any of the items. Presumably the expenses of management are either section 212 expenses or section 162 expenses. In either case, how are the deductions -13-

18 of expenses treated? Can they create PALs or are they subject to the 2% section 212 floor? Example (2): A limited partnership engaged in business (rental real estate or otherwise) has held some vacant land which it sells at a gain. If the land has been held for investment, the gain is portfolio income. There is no statutory restriction of the type of property which can be deemed held for investment. The Senate Finance Committee Report provides the following guidance (pp. 728 and 729): Dividends on C corporation stock, REIT and RIC dividends, interest on debt obligations and royalties from the licensing of property are generally included in portfolio income. Income from a general or limited partnership interest, from S corporation stock, from a grantor trust, or from the lease of property generally is not treated as portfolio income. Such interests can generate losses which may be applied to shelter unrelated income of the taxpayer. In addition, although such interests might otherwise be considered as held for investment, gains on the sale of such interests, when they are interests in passive activities, are not treated as portfolio income [sec. 469(e)(1)(A)] except to the extent gain on sale of such interests is itself attributable to portfolio income. For example, if stocks a general partnership owns a portfolio of appreciated stocks and bonds and also conducts a business activity, a part of the gain on sale of the partnership interest would be attributable to portfolio income and would, consequently, be treated as portfolio income. SFCR, pp. 728 and 729. Conf. Rep., p. 146, confirms that REIT and RIC dividends, as well as income received through real estate mortgage investment conduits, are to be treated as portfolio income. D. Exception for Pass-Through Interest. Where an individual receives interest income on debt of a passthrough entity in which he owns an interest, a problem of characterization is involved. Example: Assume an individual taxpayer own 100% of the stock of an S corporation and makes a loan to the S corporation. Assume -14-

19 further the taxpayer receives $100 of interest on this loan. Absent a special rule, the interest paid by the S corporation would add to its passive losses, and the shareholder would have $100 of portfolio income not subject to offset by passive losses. The Conference Agreement provides that, to the extent the taxpayer receives interest income with respect to a loan to a pass-through entity in which he has an ownership interest, the income should be allowed to offset the interest expense passed through to the taxpayer from the activity in the same taxable year. Conferees anticipate appropriate Treasury regulations will be provided [sec. 469(k)(4)]. Conf. Rep., pp. 146 and 147. VI. Scope of an Activity A. If two undertakings are part of the same activity, taxpayer need only establish material participation with respect to the activity itself as a whole, whereas, if there are separate activities, he must establish such participation separately for each. In the case of disposition, the scope of activity is critical in determining whether taxpayer has disposed of his entire interest in the activity or only a portion thereof. Thus, broadening the scope of activities would be helpful in proving material participation and narrowing or segmenting the scope would be helpful in allowing losses on dispositions. SFCR, pp. 738 and 739. On the other hand, if an activity produces income, the absence of material participation could be of benefit to the taxpayer in producing passive income. B. The fact that two undertaking are conducted by the same entity, such as a partnership or S corporation, does not establish they are part of the same activity and, conversely, the fact that two undertakings are conducted by different entities does not establish they are different activities. SFCR, p. 740 VII. Disposition of Interest in Passive Activity; or Interest Becoming Non-Passive A. Disposition on Death. The unabsorbed PAL of an individual taxpayer, if not previously absorbed or eliminated, will terminate on the death of a taxpayer in -15-

20 accordance with the following rule: The amount of the PAL is first compared with the gain which would be recognized if the activity had been transferred in a taxable transaction, which gain would presumably be reflected in the step-up in basis on death. The balance, if any, of the PAL is allowed as an ordinary deduction in the last taxable year of the decedent. See SFCR, p Note this test is on an activity-by-activity basis [sec. 469(g)(2)]. Example: Taxpayer dies holding two activities to which unabsorbed PALs of $100 apiece would be attributed. If both activities were sold in taxable transactions, the first passive activity would produce a gain of $150, and the second passive activity would produce a gain of $70. In these circumstances it appears that $30 of the PAL attributed to the second activity is allowed as a deduction to the decedent. B. Disposition of 100% of Interest in Taxable Transactions. (1) Stacking of Losses. In general, if a taxpayer disposes of 100% of his interest in a passive activity, any net loss, taking into account prior unabsorbed PALs and any gain or loss on the disposition transaction, is offset first against any net income or gain from other passive activities for the year, and second against any other income or gain [sec. 469(g)(1)]. Example: Assume taxpayer is engaged in passive activities A, B and C. Activity A has an unabsorbed PAL of $100. Passive activities B and C have no unabsorbed PAL. During the taxable year, 100% of Activity A is sold at a gain of $30; activity B has PALs during the year of $50; and activity C has passive income during the year of $50. The $30 gain on activity A is offset first against the $100 of unabsorbed PAL from activity A, leaving $70 of PAL from activity A to be allowed. Query whether the $50 of passive income from activity B is offset against the remaining $70 of loss first, so that only $20 of the loss can offset against other -16-

21 income, leaving taxpayer with a PAL from activity C of $50 or, in contrast, whether the $50 of gain from Activity B is offset by $50 of loss from Activity C, leaving taxpayer with no PAL and a deduction against other income of $70. (2) Multiple Activities and Multiple Entities. The Senate Finance committee Report provides the following guidance at pp. 725 and 726 as supplemented by, Conf. Rep., p. 145: A disposition of the taxpayer s entire interest involves a disposition of the taxpayer s interest in all entities that are engaged in the activity, and to the extent held in proprietorship form, of all assets used or created in the activity. If a general partnership or S corporation conducts two separate activities, a fully taxable disposition by the entity of all the assets used to create one activity constitutes a disposition of the partner s or shareholder s interest in the activity. Similarly, if a grantor trust conducts two separate activities, the grantor is considered as disposing of his entire interest in that activity. (3) Sham Transactions, Wash Sales, Etc. The Conference Agreement contemplates that transactions constituting a sale or other taxable disposition in form but which are not treated as a taxable disposition under general tax rules do not give rise to the allowance of suspended deductions. For example, sham transactions, wash sales and transfers not properly treated as sales due to the existence of a put, call, or similar right relating to repurchase do not give rise to the allowance of suspended losses. Conf. Rep., p (4) Related Party Dispositions. Under the conference Agreement, a taxpayer is not treated as having disposed of an interest in a passive activity for purposes of triggering suspended losses if he disposes of it in an otherwise fully taxable transaction to a related party within the meaning of section 267(b) or 707(b)(1) including applicable attribution rules. In the event of such a related party transaction, which is not treated as a disposition, suspended losses are not triggered but rather remain with the taxpayer. Note that the suspended losses do not increase the basis of a -17-

22 property in the hands of the transferee. The suspended losses may be offset by income from other passive activities of the taxpayer in the future. Where the related party ultimately makes a transfer in a fully taxable disposition of the activity on which the original loss was not allowed, the taxpayer can deduct the suspended losses attributable to his interest in the passive activity [sec. 469(g)(1)(B)]. Conf. Rep., p Query: If a related party dies, do suspended losses become allowable as if the transferor died? (5) Insurance Syndicates. When the owner of an interest in any insurance syndicate insuring U.S. risks disposes of his interest in the syndicate in a fully taxable closing transaction, he is treated as having made a disposition of his interest in the passive activity. Conf. Rep., p (6) Dispositions by Abandonment. The scope of a disposition triggering suspended losses under the PAL rules includes an abandonment, constituting a fully taxable event under present law, of the taxpayer s entire interest in the passive activity. For example, if taxpayer owns rental real property which he abandons in a taxable event, which would give rise to a deduction under section 165(a) of present law, abandonment constitutes a taxable disposition that triggers recognition of suspended losses under the PAL rule. Similarly, if the event of the worthlessness of a security is treated under section 165(g) as a sale or exchange of security, and the event of the worthlessness otherwise represents the disposition of an entire interest in a passive activity, it is treated as a disposition. Conf. Rep., p (7) Interaction with Capital Loss Transactions. Upon the fully taxable disposition of a taxpayer s entire interest in a passive activity, any loss on disposition which is capital loss remains subject to limitations on deduction of capital losses [sec. 469(g)(1)(C)]. Conf. Rep., p C. Disposition on Installment Sales. If a passive activity is disposed of at a gain on an installment sale, then any unabsorbed PALs from the -18-

23 activity are allowed in the year the installment obligation is collected in the same proportion that the gain recognized on the installment obligation during such year bears to the total gain to be recognized on the installment obligation [sec. 469(g)(3)]. D. Disposition by Gift. On disposition of any interest in a passive activity by gift, the basis of the transferred interest is increased by the amount of PALs allocable to the transferred interest and the PALs so allocable are not allowable as a deduction for any taxable year [sec. 469(j)(6)]. Note that basis to transferee for purposes of determining loss cannot exceed fair market value. SFCR, p E. Passive Activity Becoming Active. If a passive activity ceases to be passive, any unabsorbed PALs from such activity survive and are subject to offset by income of such activity or entity in subsequent years in accordance with the rules set out in section 469(f)(1). A closely held corporation which becomes widely held cannot offset PALs against portfolio income under section 469(f)(2), with the same rule applicable to personal service corporations changing status. Conf. Rep., pp. 139 and 140. F. Tax-Free Exchanges. For rules where there is a tax-free exchange of a passive activity under section 351, 721 or 1031, see SFCR, page 727. Apparently, a suspended PAL is ultimately allowable on the taxable disposition of acquired property. The discussion in the Senate Finance Committee Report as to allowance of unabsorbed PALs only against income from the same activity in different form would appear to be applicable only if the successor activity were not a passive activity, because if it were a passive activity, any net income would be subject to offset by any PAL. Gain recognized on the transfer of a partial interest in the passive activity, and gain (boot) on a tax-free transfer of an entire or partial interest, are treated as passive income subject to offset by losses and credits from passive activities. However, such transfers are not treated as dispositions triggering all suspended losses from the activity [SFCR, p. 719 footnote]. Query as to what the result is when a C corporation or a personal service corporation liquidates with an -19-

24 unabsorbed PAL. What happens on the termination of a trust or estate? Is it possible that on a liquidation of a corporation, if all gain or loss is recognized after the repeal of General Utilities, that the unabsorbed PALs would be recognized? What is the result if there is an asset transfer? What happens to unabsorbed PALs in the case of corporate reorganizations where assets of PAL operation move to another corporation. Is section 381 applicable? VIII. Interest Limitations on Deductions for Non-Business A. Key Statutory Terms in Defining Investment Interest. (1) Property held for investment [sec. 163(d)(5)] (2) Investment interest [sec. 163(d)(3)(A)] (3) Investment income [sec. 163(d)(4)(B)] (4) Investment expense [sec. 163(d)(4)(C)] (5) Net investment income [sec. 163(d)(4)(A)] B. Property Held for Investment. (See Exhibit B) Property held for investment is an integral part of the definition of investment interest [sec. 163(d)(3)(A)] and investment income [sec. 163(d)(4)(B)]. The words property held for investment are not defined further in the statute except by specific inclusion of: (1) Property producing portfolio income under section 469(e)(1) [which definition is partially circular because section 469(e)(1) itself includes property held for investment] [sec. 163(d)(5)(A)(i)]; and (2) An interest held by taxpayer which meets the statutory definition of a passive activity -20-

25 under section 469(c)(1) but which is nevertheless not a passive activity presumably because under regulation promulgated pursuant to section 469(k) the activity (and its related positive income) was pushed out of the passive activity basket [sec. 163(d)(5)(A)(ii)]. C. Investment Interest and Personal Interest. (See Exhibit C) (1) The definition of investment interest includes interest paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment. Investment interest includes interest expense property allocable to portfolio income under the PAL rule [sec. 163(d)(3)(A)]. Conf. Rep., p (2) The Conf. Rep. states that investment interest also includes interest expense properly allocable to an activity, involving a trade or business in which the taxpayer does not materially participate, if that activity is not treated as a passive activity under the PAL rules [sec. 163(d)(3)(B)(ii)]. This presumably covers instances where anti-abuse regulations convert income from passive to active income or portfolio income [sec. 469(k)]. Investment interest also includes the portion of interest expense incurred or continued to purchase or carry an interest in a passive activity to the extent attributable to portfolio income [sec. 163(d)(3)(A)]. Conf. Rep., p (3) Investment interest does not include any interest that is taken into account in determining taxpayer s income or loss from a passive activity [sec. 163(d)(3)(B)(ii)]. The Conf. Rep. states investment interest does not include interest properly allocable to rental real estate activity in which the taxpayer actively participates within the meaning of the passive loss rules, presumably here referring to the $25,000 exemption [sec. 469(i)]. Conf. Rep., p (4) The investment interest limitation is not intended to disallow a deduction for interest expense which in the same year is required to be -21-

26 capitalized or is otherwise specially treated, for example, construction interest subject to section 263(a) or interest disallowed under section 265 relating to tax-exempt interest. Conf. Rep., p (5) Personal interest generally includes interest on tax deficiencies but does not include qualified residence interest or interest payable on estate tax deferred under section 6163 or section 6166 [sec. 163(h)(2)]. Conf. Rep., p Detailed provisions for calculating qualified residence interest with applicable transition rules are set out in Conf. Rep., pp [sec. 163(h)(3)]. D. Investment Income. (See Exhibit D) (1) Investment income includes gross income from property held for investment, gain attributable to disposition of property held for investment and amounts treated as gross portfolio income under the passive loss rules. [sec. 163(d)(4)(B) and sec. 469(e)(1)(A)]. Investment income also includes income from interest and activities, involving a trade or business, in which the taxpayer does not materially participate, if that activity is not treated as a passive activity under the passive loss rules [sec. 469(k)(3)]. Presumably, this covers cases in which the anti-abuse regulations push trade or business activities in which taxpayer does not materially participate out of the passive activity basket because they have income. Conf. Rep., p (2) Net investment income is investment income net of investment expenses [sec. 163(d)(4)(A)]. Investment expenses are deductible expenses, other than interest, directly connected with the production of investment income [sec. 163(d)(4)(C)]. In determining deductible investment expenses, it is intended that investment expenses be considered as those allowed after application of the rule limiting deductions for miscellaneous expenses to those expenses exceeding 2% of AGI. In computing the amount of expenses that exceed the 2% floor, expenses that are not investment expenses are -22-

27 intended to be disallowed before any investment expenses are disallowed. Conf. Rep., pp. 153 and 154. IX. Phase-in; Transition Rules; Application to Minimum Tax For regular tax phase-in rules, see Conf. Rep., pp. 148 and 149, and pp. 156 and 157 (interest limitation rules). Phase-ins are not applicable to alternative minimum tax. Conf. Rep., p. 258 (passive loss rules) and p. 259 (investment interest rules). X. Examples and Queries as to the Application of PAL and Non-Business Interest Rules to Trading in Commodities, Options and Securities. Example (1): Assume an individual floor trader on a commodity exchange or option exchange has a net capital gain from the activity for the taxable year. Q(1). A(1). Could this gain be sheltered by real estate losses? No. The gain is either portfolio income or active business income. Query (A) How would the gain be treated for purposes of the investment interest limitation? If the activity is a trade or business, then income is not investment income and cannot support deduction of other unrelated investment interest. Query (B) How would the related expenses of the trader be treated? Example (2): Suppose an individual floor trader on a commodity exchange or option exchange has a net trading loss from the activity for the taxable year. Q(1). Could the trading loss offset unrelated dividend and interest income? -23-

28 A(1). Q(2). A(2). No, the loss remains a capital loss in any event, and deduction of capital losses against ordinary income of any type remains restricted. Could this trading loss offset the individual s other unrelated capital gain? Yes. The loss could not be a PAL, because, even if the capital loss were a trade or business loss, the individual materially participated. Example (3). Suppose there is a limited partnership trading in commodity futures or stock options. The limited partnership has net trading income. Query (A) How is the distributive share of this income characterized for limited partners with respect to the investment interest limitation and the PAL rules? Query (B) What is the tax treatment to the limited partners for their distributive share of management fees and other expenses? Query (C) How, if at all, would the answers to Queries (A) and (B) change if the limited partnership had a net trading loss for the year? Query (D) What would be the tax treatment of the general partner in the circumstances outlined in Queries (A), (B) and (C)? -24-

29 Donald Schapiro 9/24/86 QUESTIONS FACTS: Assume that each of the following entities is actively trading futures and options: A. Individual speculator B. Floor trader C. Limited partner in a partnership, which in addition to trading futures and options, also is a dealer in government securities D. General partner in partnership described in C above QUESTIONS: 1. Are expenses of the futures and options activity deductible under section 163 or 212? 2. Are the futures and options property held for investment for purposes of the investment interest limitations and the portfolio income exclusions of the PAL rules? 3. How is interest incurred to carry the futures and options activity treated? 4. Is income and loss from the futures and options activity investment income and loss? 5. Does the futures and options activity generate portfolio income or loss for the PAL rules? 6. Are losses from futures and options activity PALs? -25-